Moral Hazard, part twelve

While some problems can be traced far back in history, the fundamental change in the economy before the current crisis can be conveniently bounded by the War on Terror. This is a touchy subject, and I will do my best to avoid unnecessary judgments. There is an economic aspect which needs to be highlighted, especially since the attacks were conceived as economic warfare.

In short form, many people died, buildings fell, but the economy did not. The wars in Afghanistan and Iraq were financed by deficits, but this is the way wars are generally run. There was no conscription, no huge shift to war production, no huge, untapped labor force taking over jobs left open by departing servicemen. The civilian economy kept running with remarkably little change. There were no special war bonds. Scarcely anyone had to tighten their belt.

The expansion of national debt meant cautious investors with the ability to wait could get acceptable returns on bonds backed by the full faith of the government of the wealthiest and most powerful nation on earth. Concern about economic contraction as resources were diverted to war meant central banks kept the levers on the throttle for the money supply wide open. It was a situation made to attract speculative investment.

The big problem was where to get financing repeatedly for speculation at low enough rates to make this profitable. Once speculators started using ordinary sources for loans central banks would predictably tighten controls on money. This is where the hidden loopholes in bonds based on high-risk mortgages come in. Magical practices spinning the straw of sub-prime mortgages into AAA gold provided a way to circumvent regulators and ratings, by hiding risks. Effectively, many big financial institutions were printing money. While children believed in Harry Potter, adults believed in three-letter acronyms (TLA) like CDO and CDS, when presented with compelling mathematical mumbo-jumbo.

With the civilian economy bizarrely unaffected by war, borrowing could be used to finance homes in the Sunbelt for retirement or vacations. Even timeshare condominiums were a popular investment. One might have asked how retirement and vacations were going to result in economic activity to pay back these loans. By 2002 people were too busy flipping houses to care. This is a classic bubble, in which the primary idea behind investment is that you can always find a bigger fool to buy your position when you want to get out.

(Don't assume this is a purely American mess. Spain also overbuilt expensive property intended for sale or rental. The legal snarls of mortgaged property in Arizona with investors in New York and clients in Michigan pale compared to property in Spain backed by Chinese investors with clients in northern Europe financing through French or British banks. Decades may elapse before some of these are resolved.)

This is now considered ancient history. The supply of sub-prime mortgages on which those CDOs were based pretty well dried up in 2006. By 2007 there were worrying increases in the rate of defaults. Somehow, this never reached the level of weakening investments based on those mortgages until 2008. (This should have been a warning signal. Why didn't derived financial products reflect changes in the underlying assets?)

Even then denial was profound. The collapse of Bear-Stearns should have been an unmistakable wake-up call. Instead, business-as-usual continued for another six months. There were attempts to suppress adverse opinions. You can almost hear the back channel communication: "You can't publish that, it will spook the marks!"

Had investment been more transparent a correction would have started in 2006 or 2007. Had the absurdity of the whole loan repackaging business been exposed from the beginning the only people who would have put their hard-earned savings into it would have been those who patronize casinos with one-armed bandits. Instead, we all found ourselves in the middle of a crap shoot even when we made traditionally conservative investments like buying a home, or planning retirement. We didn't have to play the market ourselves, those managing our bank accounts, insurance and pension funds would do it for us.

At this point I need to step back and ask what was behind the exceptional compensation for people and organizations handling large amounts of money during the run up. Conventional explanations talk about deep knowledge acquired over many years, great skill and enormous responsibilities.

In 1992, long before recent fiascoes, legendary investor Felix Rohatyn described derivatives this way "26-year-olds with computers are creating financial hydrogen bombs." (By 2003 Warren Buffet was talking about "financial weapons of mass destruction".) During the run up phase of a bubble you can make money by investing almost anywhere, without regard to risk. When expertise becomes most important, it is in the period where it is still possible to get out and keep your shirt. How did our experts do during this phase?

The answer I get is that you could do better by taking their reassurances to mean exactly the opposite of what they said. In fact, my own theory is that it is easy to find bad financial advice which is an even better leading indicator of what not to do. When my mailbox recently produced a card touting "unlimited potential" and "great leverage", it confirmed my belief that the time to get out of any leveraged investment had come, (had I been in the market.)

With knowledge and skill discounted, we have to look into responsibility. Do CEOs with golden parachutes show responsibility to stockholders? Does the ability to call the Secretary of the Treasury (or the Chairman of the Fed.) when you get in trouble encourage responsible behavior? How many financial leaders made hard decisions early enough to make a big difference in outcome?

How many organizations with highly-compensated staffs of thousands did better than Warren Buffet and his more modestly compensated staff of 20? I could make a good case that the correlation between compensation and responsibility becomes negative at a surprisingly low level. People who really need their jobs will be very cautious about risking them.

Mysterious flows of information and money have produced predictable results. Given the structure of incentives, and the debased currency of financial information, what the invisible hand of the marketplace did was, in a sense, completely predictable in outline, even if the specific sequence and timing of events was unique to particular circumstances.

While many are busy trying to affix blame to others, the circus has not ended, just moved from one ring to another. At present those mortgages ending in short sales, defaults and/or foreclosures have produced a new kind of financial product. There is a very active market in 'deficiencies' of mortgage contracts. Packages of these are being sold.

People who lost their homes and savings are still being dunned for money they were not able to pay for overpriced real estate, despite the fact that financial institutions have seized the property and resold it, in the process unequivocally demonstrating that it was not worth the loan value. The people most targeted are those without money to pay attorneys. Fiduciary responsibility now seems to apply only to people with the least financial expertise.

Has finance improved with respect to transparency and accountability? At the beginning of the crisis, there were more, and more varied, major financial institutions. Some were brokerages, some insurance companies, some investment or commercial banks, some partnerships. The major firms have now become bank holding companies. The limited liability of corporate law places those making decisions farther from consequences of their actions than before. Rational investors, (should any still exist,) now have to evaluate another level of quarterly reports and 10ks to decide what an investment in these might be worth.

Almost all surviving firms are huge. Evaluating any one of them is the examiner's equivalent of climbing Everest or K2. It is apparent from the behavior of markets you can't simply remove doubts about real value by calling in auditors. People won't believe them.

This is no longer a question of us and them. Assigning blame is not going to resolve the problem. If criminal prosecution were going to be effective, it should have been started years ago. At present the roots of past disaster lie at or beyond limits set by statutes of limitations.

My own prescription would be a renewed commitment to honesty, transparency and accountability, particularly concerning risk, with a thorough overhaul of institutions which fall short of these standards. An economy based on deception is a dead end. There is another important aspect, a willingness to live and work with people even when you can only agree to disagree.

One point I keep trying to illustrate is the empirical nature of our economic successes. Nobody is consistently right about the future. The basis of robust economic decisions is closely linked to political pluralism. Having read "The Wealth of Nations" I can tell you it mainly talks about what governments should not do. Capitalism is simply not a form of government. Regardless of systems of government the underlying requirement for continued economic success is pluralism. This includes the right to be wrong. (Though not full immunity from consequences of being wrong, which destroys useful feedback.)

Unfortunately, we are now entering a typical eighteen-month election year, when the silly season never ends. I had better pause here, until I get over that thought.


Looks like you have have plenty of material if you decided to write a book.

If the bankers had their compensation set-up differently. In a way where they had actual 'skin in the game" when it came to their compensation packages, don't you know they would have acted much differently! You probably saw the TV documentary (think it was called house of cards) where one email said something to the effect; doesn't matter to me, I will be rich by when the whole house of cards comes tumbling down. Many of them knew exactly what they were doing.

Of course the faux AAA ratings and bond insurers made it possible to sell this junk around the world to any pension fund, municipality, or sucker looking for more yield.

Funny thing is, there is another dynamic in the mortgage market today that is working in favor of the bankers. Again! A dynamic that is making the housing market recovery impossible and benefiting the bankers.

Consumers are being shut out of the mortage market due to poor credit scores and over-conservative mortage guidelines. Consumers don't have access to the lowest rates on history to aid a housing recovery. For instance, If one is trying to buy a property that is being given away at 30 cents on the dollar, AND has a 50% down payment, the banks won't loan on it if the buyer has had a foreclosure in the last 3 years. Not even with 50% or more down!

The mortages companies all have the same business model set up to sell the stuff off to Fannie and Freddie. One that has specific guidelines for borrows that shuts many would be buyers out.

No doubt, some private equity fund has access to all this sper cheap money and is buying up all the assets. Another huge wealth transfer.

If I had money, I would set up a bank and start doing home loans at like 7%. Borrow all the cash from the Fed at zero, and lend it at 7-8% to buyers with marginal credit. Huge opportunity right now.However, the way the current system is, homes are selling for 50 cents on the dollar(in some markets) and home buyers are shut out.

The books are out there, though none I know of have centered on the theme of moral hazard. Too many of them go the route of demonization of individuals. The idea that those individuals at the top were simply selected and trained by the culture permeating the entire business isn't a recipe for book sales.

Current lending practices go beyond what you have described. Entire areas have simply been 'red-lined'. Nobody, (except possibly your brother-in-law,) will lend you money to buy there. Developers aren't interested in fixing buildings unless there is a sucker who will pay exorbitant rates. They are waiting for the area to implode, so they can buy the whole thing for a song, and send in the bulldozers. Another angle is to get government, local, state or federal, to guarantee a redevelopment of the area. Until those guarantees are available (to the right people), all efforts to reverse the slide will be undermined as wasteful spending.

Another angle which came to my attention recently has to do with tax exemptions on agricultural land. These are being called unfair. While the neighbors may feel a farm should pay more, I believe the forces behind a concerted push are developers waiting for a slow economy to push farms into forced sales. As it happens, this is another case where family experience has been there before.

There are large topics I haven't touched, like the role of Fannie Mae. If you keep paying bright and persistent people with a stake in the outcome to outwit a bureaucratic operation like that, eventually they will succeed. Guess who fueled much of the expansion of subprime debt, and ended up with huge losses.

It's probably a good thing you can't put your banking scheme into practice. I've tried to help some individuals. The idea was that I would buy property being sold cheap, they would live in it, and pay me rent for two years, until the economy picks up. I would pay cash, bear the capital costs, and take those risks, they would only pay the non-capital costs of ownership, so it didn't cost me to hold the property. In the meantime they would have a place to live. It turns out that buying some of those cheap properties listed for sale is easier said than done.

If you aren't the right person, you will be told the property is already under contract, but the listing has not been updated. If you keep checking, you will get other run-arounds. If you are very persistent, the listing will be withdrawn. If you happen to make a bid, you will be told there are multiple offers, and invited to make your "best and final" offer. When you do, you will be told you lost. Check back when the sale price is posted and you could get the suspicion your "best and final" bid was deliberately leaked. Outsiders probably need to pay 25% more than insiders. The spread is what makes insiders worth knowing.

Is it "the bank" doing this, or a clerk in the bank? The government, or an agency? Realtors? Brokers? One consistent feature of scams is that you are never sure exactly whom you are doing business with, or bidding against. Many people with mortgage trouble don't even know whom to talk to until a letter arrives from some business they never heard of informing them to pay up or move. Getting into trouble was much easier. A broker who knew all about the bank, the law and the realtor would prepare the paperwork for you so it would zip through approval. All you had to do was sign.

I've had people come to me for help who were shocked to learn the broker was not representing either their interests or the bank's. While in principle such a professional is responsible for complying with things like "truth in lending" laws, in practice he was simply a cut-out. The bank didn't know, and did not want to know, how the paperwork corresponded to reality. They were off the hook. (With millions of defaults in the courts, how many prosecutions for violations of "truth in lending" will go to trial?)

If such an individual broker happens to work for a company which is part of a kind of fairy ring of companies controlled by two people, specializing in every aspect from property acquisition to building, appraisals, investment, mortgages, accounting and taxes, and if the person actually preparing the loan application has the official title of general manager, with only a secretary/receptionist to manage, a prudent person would beat a hasty retreat. Most people buying homes did not check.

I just checked on one example I've followed in detail. It was sold for 32 cents on the dollar, but not to me.
That's sick if farmers would suddenly have a tax exemption removed on farm land which could force them into financial hardship. You have a link on that?

Sounds like you had a potential win-win set up with financing those homes. Sorry that didn't work out better. Nice to help somebody and help yourself too. Obviously helps to have a tenant that will stick around and take care of the place. If one has to go the property manager route, he/she can get into trouble if the property is mis-managed.

I know what you mean about certain real estate transactions. I think it varies from state to state also. I'm from the left coast, and invested a bit out of state in the past. Other areas do things differently than one is accustomed to in his own area, kind of like you describe. Many of the good deals often don't hit MLS, and your broker is not necessarily working in your best interest. All kinds of squirrley stuff goes on.

Here is another article that goes along the lines of the big guys swooping to buy everything in site at a steep discount. Maybe you already saw this one, if not be a good one to add to your mental database. :eek:)

The largest transfer of wealth from the public to private sector is about to begin. The federal government will be bulk-selling the massive portfolio of foreclosed homes now owned by HUD, Fannie Mae and Freddie Mac to private investors -- vulture funds.

These homes, which are now the property of the U.S. government, the U.S. taxpayer, U.S. citizens collectively, are going to be sold to private investor conglomerates at extraordinarily large discounts to real value.

You and I will not be allowed to participate. These investors will come from the private-equity and hedge-fund community, Goldman Sachs(GS_) and its derivatives, as well as foreign sovereign wealth funds that can bring a billion dollars or more to each transaction.
markmc20001;bt5567 said:
That's sick if farmers would suddenly have a tax exemption removed on farm land which could force them into financial hardship. You have a link on that?
That was the result of a direct personal communication. The change has not taken place, but lobbying seems to be underway, at least at state levels. I'm not sure about federal. With the chaos in Congress it is not always clear who is behind what. Treat this as a rumor for now.

Don't give the "left coast" a free pass. The region gave us WaMu, which approved a mortgage using a picture on file with an applicant in costume for a mariachi band as evidence of ability to make payments. California provided a strawberry picker making $14,000/year with a mortgage of nearly 3/4 million. The main reason California, land of Michael Milken, has not been prominent in later festivities is that their real estate was already priced out of sight. Check next door in Arizona and Nevada for the wild west.

My own line on the money behind some particular Sunbelt squirrels leads in two directions: New York and California.

I have other stories about short sales. The process is about as far from transparent as possible. If you don't have six months to wait on a deal, give it a pass. For the bank it looks like an option on real estate futures. They can screw around for months, and reject the deal on any number of grounds. Meanwhile, the buyer is locked in to a fixed-price contract.

Major banks are gearing up to double the rate at which they process short sales. Don't expect a lot of financial or real estate acumen, they are hiring temps.
This is fascinating, I just spent all year investigating homes/condos for my own residence. I live in a fairly robust college/govmt town in midwest that wasn't hit as hard as the coasts by mortgage crisis and it still has pockets of town that sell quickly and not bad prices, they are on an isthmus and thus finite. I looked at one home a few weeks ago that a local bank fixed up! They figured that it would help the sale and I am sure that realtor would have been happy to sell it to me, it was priced very economically, it was a foreclosure. I could not get over that the bank fixed it up, they did a nice job but the outgassing was over the top for me.

I chose not to use a realtor as for me they were the obvious point of corruption in the past, pretend to be your "advocate" when they may be looking out for own interest first, although I don't think they are all that way here, it is the dairybelt and there is still quite a
bit of wholesomeness here and if you deal with a credit union you can get pretty good service and rates as long as your ccredit rating is good. I did see multiple offers on some properties priced well in popular areas. I knew the realtors in some of those situations and in some cases it was above board, there was one situation where I thought the realtor went
and told another interested party they should get their offer in and at what price after a young couple put in an offer and were suddenly told there was already a better offer.

I considered a short sale, because you can write in the offer that you can get out of it at any time to go for something else so it doesnt have to tie up your life for 6 months. A realtor handling f/c told me she felt we hadnt hit bottom yet but are near the bottom, I was surprised she would admit it, it has been an interesting year, learned a lot, calling up listing realtors and talking to all of them gives a broad perspective and watching the local market so closely start to see whats going on.
A savvy friend of mine thinks we definitely have farther down to go, esp depending on where you live but that the country will be in like a 20 year stagnation. I wouldnt be surprised and that scares me from buying but I decided you have to live somewhere and if you invest in property it is something real whereas money in the bank is abstract, I could see them devising a scam to get that, like savings interest rates going negative or something.
I didn't mean for my note above to have strange margins, something is off with the program here today.....
In our state the tool of a governor (he is a disciple of the Koch brothers) allowed to go thru in his larger bill this year an item giving
banks the option to buy credit unions more easily without the members having a say. I cannot emphasize enough how fabulous credit
unions have been here on better rates, low fees, customer service......the CU's were not happy that governor didnt veto this and I see it as another set up for the banks to try to grab something working well and destroy it at some point. They really don't think about the
big picture tho--if they completely destroy the middle class how are they going to keep making money?
This is partly to check on those margins. Once we get a good post you can go back, and edit yours above.

One heartwarming feature of the federal program to deal with toxic assets of banks was the special provision that the first two weeks a foreclosed house was on the market would be reserved for bids by owner/occupants. Did you know you could live in another state and register the title in your wife's name? How many people do you think the government has checking that owner/occupants are really what they claim?

Here's another scam I ran across, overpay on the tax stamp when you register a title transfer to inflate the value. In one example, a house was bought from the government for $61,500, but the tax stamps made it look like $81,500. The resulting apparent price meant new buyers could get a government-backed loan for $104,500. Had the true previous sale price been used this would have been too large an increase in a short period to qualify. The zinger in all this was that nobody had previously considered that anyone would want to overpay tax stamps. There are no statutes preventing this, and crime is statutory.

The end buyers were told the $104,500 price, so they can't exactly claim fraud. Their names are on the mortgage application, which was approved based on false information. Are they going to squawk, and lose their new home?

This scam only worked in one county. That county has now started recording the actual sale price on titles. If real estate prices made any sense, someone would have noticed that a house bought from the government was suddenly selling for a 70% higher value. It slipped past. You get a sense of the kind of people who managed to inflate the real estate market, and leave the taxpayers holding the bag. They are still working hard to exploit every opening. How much has really changed?
If you had cash in the last few years and you enjoyed fixing up and managing property you could make a lot. I know someone who with her husband was buying HUD houses for cash, about $30,000, 3 bedrooms 1 or 2 baths in a middle class neighborhood. You can only get a mortgage on a HUD house (and put down $100) if you live there. They'd fix them up--nothing major, new carpet, maybe fixtures and some renovation, and let's say they put $40,000 into the houses. They rented quickly for $900/mo. That's going to be paid off completely in four years and then it's all profit. However there is associated stress. 1) You need to know where to get the right labor and parts for cheap and to be able to assess a house quickly in terms of the cost of fixing 2) You need to be willing to drive out there and show it multiple times 3) You need to account for the occasional defaulting tenant even with a good credit check and references as circumstances change and it can be hard then to get someone out 4) You need to account for slow times--if you have numerous properties, sometimes one will be slow to rent and take a lot of effort, and you need to be creative in figuring out how to make up for those times (in fact I met this person because I tried one of her apartments in February, it was her first investment in a posh neighborhood, a four family small house) for a month. She let me try it as long as she could show it, I'm MCS so I needed the trial and as it turned out it wasn't right for me. She filled the space, got rent, continued to show it sporadically, and I left when someone took a lease. 5) You have to like people, and weather stress well. You have to really put the right clauses in the lease about everything and protect yourself. You have to have good people for repairs, tenant complaints etc.

It's not a low stress investment, but it is self-directed and there were fabulous opportunities. I thought of doing it even with a HUD house that I took a mortgage on ($100 down? How bad could it be) but I can't deal with the extra stress and responsibility.

Right now if I felt I could park some cash I'd find a way to invest in farmland like Buffett. Food prices are going to soar. Food is going to be more important than gold. Small investors have only a few options but there are some.
PS, I mean $40,000 total--$30,000 to buy (you'd bid on them at auction) and $10,000 to fix up.
Jen, it seems in midwest they are trying to crash the small farmers so its going to be just big agribusiness for the most part. I can see where farms are a good investment but where specifically would the little guy get in?

I agree about it not being low stress in regard to renting property, I was briefly a landlord once and it wasn't even that demanding of a situation but there were some issues with the tenant and also like you said managing the work even if I didn't have to personally do it, was just not for me. If I get desperate I will consider a roommate but my new place is set up
where I can get some space from them and they have own bathroom, I am self conscious about the m.e. stuff and don't
want an observer to how much I have to lie around!

Blog entry information

Last update

More entries in User Blogs

More entries from anciendaze